by Peter Lynch
So with Ford selling for $38, you were getting the $16.30 in net cash and another $16.60 in the value of the finance companies, so the automobile business was costing you a grand total of $5.10 per share. And this same automobile business was expected to earn $7 a share. Was Ford a risky pick? At $5.10 per share it was an absolute steal, in spite of the fact that the stock was up almost tenfold already since 1982.
Boeing is another cash-rich stock. In early 1987 it sold in the low $40s, but with $27 in cash, you were buying the company for $15. I tuned in to Boeing with a small position in early 1988, then built it up to a major one—partly because of the cash and partly because Boeing had a record backlog of commercial orders yet to be filled.
Cash doesn’t always make a difference, of course. More often than not, there isn’t enough of it to worry about. Schlumberger has a lot of cash, but not an impressive amount per share. Bristol-Myers has $1.6 billion in cash and only $200 million in long-term debt, which produces an impressive ratio, but with 280 million shares outstanding, $1.4 billion net cash (after subtracting debt) works out to $5 per share. The $5 doesn’t count for much with the stock selling for over $40. If the stock dropped to $15, it would be a big deal.
Nevertheless, it’s always advisable to check the cash position (and the value of related businesses) as part of your research. You never know when you’ll stumble across a Ford.
As long as we’re on the subject, what is Ford going to do with all its cash? As cash piles up in a company, speculation about what will become of it can tug at the stock price. Ford’s been raising the dividend and buying back shares at a furious pace, but it has still amassed excess billions over and above that. Some investors wonder if Ford will blow the money on a you-know-what, but so far, Ford has been prudent in its acquisitions.
Already Ford owns a credit company and a savings-and-loan, and it controls Hertz Rent A Car through a partnership. It made a low bid for Hughes Aerospace but lost out. TRW might create sensible synergy: it’s a major worldwide producer of automotive parts and is in some of the same electronics markets. Furthermore, TRW could become the major supplier of airbags for cars. But if Ford buys Merrill Lynch or Lockheed (both were rumored), will it join the long list of diworseifiers?
THE DEBT FACTOR
How much does the company owe, and how much does it own? Debt versus equity. It’s just the kind of thing a loan officer would want to know about you in deciding if you are a good credit risk.
A normal corporate balance sheet has two sides. On the left side are the assets (inventories, receivables, plant and equipment, etc.). The right side shows how the assets are financed. One quick way to determine the financial strength of a company is to compare the equity to the debt on the right side of the balance sheet.
This debt-to-equity ratio is easy to determine. Looking at Ford’s balance sheet from the 1987 annual report, you see that the total stockholder’s equity is $18.492 billion. A few lines above that, you see that the long-term debt is $1.7 billion. (There’s also short-term debt, but in these thumbnail evaluations I ignore that, as I’ve said. If there’s enough cash—see line 2—to cover short-term debt, then you don’t have to worry about short-term debt.)
A normal corporate balance sheet has 75 percent equity and 25 percent debt. Ford’s equity-to-debt ratio is a whopping $18 billion to $1.7 billion, or 91 percent equity and less than 10 percent debt. That’s a very strong balance sheet. An even stronger balance sheet might have 1 percent debt and 99 percent equity. A weak balance sheet, on the other hand, might have 80 percent debt and 20 percent equity.
Among turnarounds and troubled companies, I pay special attention to the debt factor. More than anything else, it’s debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debts are always at risk.
Once I was looking at two depressed stocks in technology: GCA and Applied Materials. Both manufactured electronic capital equipment—machines to make computer chips. It’s one of those highly technical fields that’s best avoided, and these companies had proven it by falling off the ledge. In late 1985, GCA stock fell from $20 to $12, and Applied Materials did even worse, falling from $16 to $8.
The difference was that when GCA got into trouble, it had $114 million in debt, and almost all of it was bank debt. I’ll explain this further on. It only had $3 million in cash, and its principal asset was $73 million of inventories—but in the electronics business, things change so fast that one year’s $73-million inventory could be a $20-million inventory the next. Who knows what they could really get for it in a fire sale?
Applied Materials, on the other hand, had only $17 million in debt and $36 million in cash.
When the electronic-components business picked up, Applied Materials rebounded from $8 to $36, but GCA wasn’t around to enjoy the revival. One company went kaput and was bought out at about 10 cents a share, while the other went up more than fourfold. The debt burden was the difference.
It’s the kind of debt, as much as the actual amount, that separates the winners from the losers in a crisis. There’s bank debt and there’s funded debt.
Bank debt (the worst kind, and the kind that GCA had) is due on demand. It doesn’t have to come from a bank. It can also take the form of commercial paper, which is loaned from one company to another for short periods of time. The important thing is that it’s due very soon, and sometimes even “due on call.” That means that the lender can ask for his money back at the first sign of trouble. If the borrower can’t pay back the money, it’s off to Chapter 11. Creditors strip the company, and there’s nothing left for the shareholders after they get through with it.
Funded debt (the best kind, from the shareholder’s point of view) can never be called in no matter how bleak the situation, as long as the borrower continues to pay the interest. The principal may not be due for 15, 20, or 30 years. Funded debt usually takes the form of regular corporate bonds with long maturities. Corporate bonds may be upgraded or downgraded by the rating agencies depending on the financial health of the company, but whatever happens, the bondholders cannot demand immediate repayment of principal the way a bank can. Sometimes even the interest payments can be deferred. Funded debt gives companies time to wiggle out of trouble. (In one of the footnotes of a typical annual report, the company gives a breakdown of its long-term debt, the interest that is being paid, and the dates that the debt is due.)
I pay particular attention to the debt structure, as well as to the amount of the debt, when I’m evaluating a turnaround like Chrysler. Everyone knew that Chrysler had debt problems. In the famous bailout arrangement, the key element was that the government guaranteed a $1.4-billion loan in return for some stock options. Later the government sold these stock options and actually made a big profit on the deal, but at the time you couldn’t have predicted that. What you could have realized, though, was that Chrysler’s loan arrangement gave the company room to maneuver.
I also saw that Chrysler had $1 billion in cash, and that it had recently sold off its tank division to General Dynamics for another $336 million. True, Chrysler was losing a small amount of money at the time, but the cash and the structure of the loan from the government told you that the bankers weren’t going to shut the place down for at least a year or two.
So if you believed the auto industry was coming back, as I did, and you knew that Chrysler had made major improvements and had become a low-cost producer in the industry, then you could have had some confidence in Chrysler’s survival. It wasn’t as risky as it looked from the newspapers.
Micron Technology is another company that was snatched from oblivion by the debt structure—and Fidelity had a major hand in it. This was a wonderful company from Idaho that staggered into our office on its last legs, a victim of the slowdown in the computer memory-chip industry and of the Japanese “dumping” of DRAM memory chips on the market. Micron sued, claiming that there was no way the Japanese could produce chips at lower cost than Micron,
and therefore the Japanese were selling the merchandise at a loss to drive out the competition. Eventually Micron won the suit.
Meanwhile, all of the important domestic producers except Texas Industries and Micron got out of the business. Micron’s survival was threatened by the bank debt it had built up, and its stock had fallen from $40 to $4. Its last hope was selling a large convertible debenture (a bond that can be converted into stock at the buyer’s discretion). This would enable the company to raise enough cash to pay off the bank debt and ride out its short-term difficulties, since the principal on the convertible debenture wasn’t due for several years.
Fidelity bought a large part of that debenture. When the memory-chip business turned around and Micron returned to profitability, the stock rose from $4 to $24, and Fidelity made a nice gain.
DIVIDENDS
“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”
—John D. Rockefeller, 1901
Stocks that pay dividends are often favored over stocks that don’t pay dividends by investors who desire the extra income. There’s nothing wrong with that. A check in the mail always comes in handy, even for John D. Rockefeller. But the real issue, as I see it, is how the dividend, or the lack of a dividend, affects the value of a company and the price of its stock over time.
The basic conflict between corporate directors and shareholders over dividends is similar to the conflict between children and their parents over trust funds. The children prefer a quick distribution, and the parents prefer to control the money for the children’s greater benefit.
One strong argument in favor of companies that pay dividends is that companies that don’t pay dividends have a sorry history of blowing the money on a string of stupid diworseifications. I’ve seen this happen enough times to begin to believe in the bladder theory of corporate finance, as propounded by Hugh Liedtke of Pennzoil: The more cash that builds up in the treasury, the greater the pressure to piss it away. Liedtke’s first claim to fame was building a small oil company, Pennzoil, into a strong competitor. His second claim to fame was beating Texaco (the Goliath) out of $3 billion in a court battle that everyone said Pennzoil (the David) would lose.
(The period of the late 1960s discussed earlier ought to be remembered as the Bladder Years. Still today, there is a propensity among corporate managers to piss away profits on ill-fated ventures—but much less than twenty years ago.)
Another argument in favor of dividend-paying stocks is that the presence of the dividend can keep the stock price from falling as far as it would if there were no dividend. In the wipeout of 1987, the high-dividend payers fared better than the nondividend payers and suffered less than half the decline of the general market. This is one reason I like to keep some stalwarts and even slow growers in my portfolio. When a stock sells for $20, a $2 per share dividend results in a 10 percent yield, but drop the stock price to $10, and suddenly you’ve got a 20 percent yield. If investors are sure that the high yield will hold up, they’ll buy the stock just for that. This will put a floor under the stock price. Blue chips with long records of paying and raising dividends are the stocks people flock to in any sort of crisis.
Then again, the smaller companies that don’t pay dividends are likely to grow much faster because of it. They’re plowing the money into expansion. The reason that companies issue stock in the first place is so they can finance their expansion without having to burden themselves with debt from the bank. I’ll take an aggressive grower over a stodgy old dividend-payer any day.
Electric utilities and telephone utilities are the major dividend-payers. In periods of slow growth they don’t need to build plants or expand their equipment, and the cash piles up. In periods of fast growth the dividends are lures to attract the enormous amounts of capital that plant construction requires.
Consolidated Edison has discovered it can buy extra power from Canada, so why should it waste money on expensive new generators and all the expense of getting them approved and constructed? Because it has no major expenses these days, Con Ed is amassing hundreds of millions in cash, buying back stock in above-average fashion, and continually raising the dividend.
General Public Utilities, now recovered from its Three Mile Island mishap, has reached the same stage of development that Con Ed did ten years ago (see chart). It, too, is now buying back stock and raising the dividend.
DOES IT PAY?
If you do plan to buy a stock for its dividend, find out if the company is going to be able to pay it during recessions and bad times. How about Fleet-Norstar, formerly Industrial National Bank, which has paid uninterrupted dividends since 1791?
If a slow grower omits a dividend, you’re stuck with a difficult situation: a sluggish enterprise that has little going for it.
A company with a 20-or 30-year record of regularly raising the dividend is your best bet. Stocks such as Kellogg and Ralston Purina haven’t reduced dividends—much less eliminated them—through the last three wars and eight recessions, so this is the kind you want to own if you believe in dividends. Heavily indebted companies like Southmark can never offer the same assurance as a Bristol-Myers, which has very little debt. (In fact, after Southmark recently suffered losses from its real estate operations, the stock price plummeted from $11 to $3 and the company suspended the dividend.) Cyclicals are not always reliable dividend-payers: Ford omitted its dividend back in 1982 and the stock price declined to under $4 per share (adjusted for splits)—a 25-year low. As long as Ford doesn’t lose all its cash, nobody has to worry about their omitting dividends today.
BOOK VALUE
Book value gets a lot of attention these days—perhaps because it’s such an easy number to find. You see it reported everywhere. Popular computer programs can tell you instantly how many stocks are selling for less than the stated book value. People invest in these on the theory that if the book value is $20 a share and the stock sells for $10, they’re getting something for half price.
The flaw is that the stated book value often bears little relationship to the actual worth of the company. It often understates or overstates reality by a large margin. Penn Central had a book value of more than $60 a share when it went bankrupt!
At the end of 1976, Alan Wood Steel had a stated book value of $32 million, or $40 per share. In spite of that, the company filed for Chapter 11 bankruptcy six months later. The problem was that its new steelmaking facility, worth perhaps $30 million on paper, was ineptly planned, and certain operational flaws rendered it practically useless. To pay off some of the debt, the steel-plate mill was sold to Lukens Corp. for somewhere around $5 million, and the rest of the plant was presumably sold for scrap.
A textile company may have a warehouse full of fabric that nobody wants, carried on the books at $4 a yard. In reality, they couldn’t give the stuff away for 10 cents. There’s another unwritten rule here: The closer you get to a finished product, the less predictable the resale value. You know how much cotton is worth, but who can be sure about an orange cotton shirt? You know what you can get for a bar of metal, but what is it worth as a floor lamp?
Look what happened a few years ago when Warren Buffett, the savviest of investors, decided to close down the New Bedford textile plant that was one of his earliest acquisitions. Management hoped to get something out of selling the loom machinery, which had a book value of $866,000. But at a public auction, looms that were purchased for $5,000 just a few years earlier were sold for $26 each—below the cost of having them hauled away. What was worth $866,000 in book value brought in only $163,000 in actual cash.
If textiles had been all there was to Buffett’s company, Berkshire Hathaway, it would have been exactly the sort of situation that attracts the attention of the book-value sleuths. “Look at this balance sheet, Harry. The looms alone are worth $5 a share, and the stock is selling for $2. How can we miss?” They could miss, all right, because the stock would drop to 20 cents as soon as the looms were carted off to the nearest lan
dfill.
Overvalued assets on the left side of the balance sheet are especially treacherous when there’s a lot of debt on the right. Let’s say that a company shows $400 million in assets and $300 million in debts, resulting in a positive book value of $100 million. You know the debt part is a real number. But if the $400 million in assets will bring only $200 million in a bankruptcy sale, then the actual book value is a negative $100 million. The company is less than worthless.
This is essentially what happened to the unlucky investors who bought stock in Radice, a Florida land-development company listed on the New York Stock Exchange, on the strength of its $50 a share in total assets, which must have looked pretty enticing with the stock at $10. But much of the value in Radice was illusory, the result of the strange rules of real estate accounting, in which the interest that’s owed on the debt is counted as an “asset” until the project is completed and sold.
That’s okay if the project succeeds, but Radice couldn’t find any takers for some of its major development projects, and the creditors (banks) wanted their money back. The company was heavily indebted, and once the bankers called in their chits, the assets on the left side of the balance sheet disappeared while the liabilities remained. The stock price dropped to 75 cents. When the actual worth of a company is a minus $7 and enough people figure it out, it never helps the stock price. I ought to know. Magellan was a large shareholder.
When you buy a stock for its book value, you have to have a detailed understanding of what those values really are. At Penn Central, tunnels through mountains and useless rail cars counted as assets.
MORE HIDDEN ASSETS